Blog Post

Blogs review: The expansionary effect of bond vigilantes

What’s at stake: An FT column by Kenneth Rogoff – where the author argued that the UK’s austerity approach was an adequate insurance policy against the possibility that investors would stop buying British government debt – has generated an interesting debate in the blogosphere about whether an attack of bond vigilantes would actually be contractionary for a country that still retains a floating exchange rate.

By: Date: October 8, 2013 Topic: Global Economics & Governance

What’s at stake: An FT column by Kenneth Rogoff – where the author argued that the UK’s austerity approach was an adequate insurance policy against the possibility that investors would stop buying British government debt – has generated an interesting debate in the blogosphere about whether an attack of bond vigilantes would actually be contractionary for a country that still retains a floating exchange rate.

The analytics of invisible bond vigilantes

Paul Krugman writes that as far as he knows, none of the people issuing dire warnings about bond vigilantes have actually tried to write down a model of what an attack would look like. And there is, I suspect, a reason: it’s quite hard to produce a model in which bond vigilantes have major negative effects on a country that retains a floating exchange rate. In a simple Mundell-Fleming model, an attack by bond vigilantes has very different effects on a country with a fixed exchange rate (or a shared currency) versus a country with a floating exchange rate. In the latter case, in fact, loss of confidence is expansionary.

Kenneth Rogoff writes that Krugman has stripped the argument down to its bare analytical essentials with his signature elegance, and I agree that very likely something quite similar could be demonstrated in a more fully fleshed-out “New Open Economy Macroeconomics” model. The analysis is completely internally consistent within its own universe. The question I would pose is whether the model is consistent with the universe the UK would live in after a euro breakup.

John McHale writes that the key to the expansionary result in Paul’s model is what happens to the exchange rate.   Using a standard interest rate parity condition with a risk premium, an increase in the premium leads to a downward jump in the exchange rate.   (Essentially, the exchange rate must fall sufficiently to create expectations of future appreciation that are sufficient to maintain the interest rate parity condition.)   With nominal rigidities, the nominal exchange rate depreciation is also a real exchange rate depreciation, and hence the expansionary force. 

The importance of bank funding costs

John McHale writes that Krugman attains the expansionary result from assuming that the rates at which the private sector can borrow are unaffected by the creditworthiness shock. The euro zone experience should give some pause. What the stripped down model leaves out is that central bank is only directly affecting the overnight lending rate between banks, and also possibly future expectations of this rate.  Although UK banks are in better shape than peripheral-country banks, a creditworthiness shock to the government would still be likely to affect their funding costs and thus push up borrowing rates for households and firms.  How the balance between the expansionary force from the exchange rate and the contractionary force from credit risk would play out I don’t know. 

Frances Coppola writes that stressed banks would as a last resort still be able to borrow at close to that rate directly from the central bank. After all, there is no reason for the central bank to charge market rates for secured borrowing using pre-positioned collateral, and if it is intent on maintaining a low policy rate in the face of market determination to push up yields it could offer funding to banks at far more favorable terms as a means of bringing down market rates. 

John McHale notes that countries in the euro zone with stressed sovereigns are still facing relatively high average funding rates and charging relative high interest rates on loans, even though they have access to cheap central bank funding. This includes cheap longer-term funding through the LTROs. Collateral constraints may limit access to central bank funding, but there also seems to be an unwillingness to rely too heavily on central bank, possibly because of implications for their ability to raise non-collateralized funding from non-official sources.

Inflationary financing for a country with its own currency

Paul Krugman writes even if there is somehow a squeeze on long-term bonds, why can’t the central bank just buy them up? Yes, this is “printing money” – but when you’re in a liquidity trap, that doesn’t matter. 

Kenneth Rogoff writes that it is likely that the answers will also be quite sensitive to long-term debt sustainability and future inflation. The aftermath of a euro breakup is exactly a situation where credibility would be everything. In arguing that the UK can always just print money, Profs Krugman and Simon-Wren Lewis take for granted the credibility of long-term fiscal sustainability and the Bank of England’s commitment to maintain low inflation. Yes, a country with its own currency has the ability to escape a debt crisis through seigniorage and inflation, but this works only insofar as the inflation is not priced in. In reality, having one’s own currency is hardly absolute protection against speculative attacks and default; it only morphs their expression. This is a matter of calibration, simply spending huge amounts of money is not always a panacea in an uncertain world, and there has to be a balance between stimulus and stability.

Giancarlo Corsetti and Luca Dedola write that the historical record warns against overplaying the idea that an ‘own currency’ be an easy way out of sovereign default. Outright default on public debt denominated in domestic currency is far from rare, also in countries where policymakers are in principle in control of the ‘printing press’. In a long sample ending in 2005, Reinhart and Rogoff (2011) document 68 cases of overt domestic default (often coinciding with external debt default).

Simon Wren-Lewis writes that pretty well everyone agrees that printing money to cover unsustainable budget deficits is inflationary. But that is not what we are talking about here. We are talking about a government with a long-term feasible plan for debt sustainability, faced with an irrational market panic. In those circumstances, printing money will be purely temporary, for as long as the panic lasts. As it is taking place in the depth of a recession, it will not be inflationary.

Further ingredients to make the bond vigilantes attack contractionary

Kenneth Rogoff writes that Krugman’s comment shows that even if a euro collapse would have led to a run on sterling, the result would be depreciation of the pound and a rise in demand for British traded goods. At the same time, he argues that even if this built-in automatic stabilizer were not enough to prevent a “squeeze” on long-term bonds, the Bank of England could just print money and buy them up en masse thanks to the liquidity trap. 

Kenneth Rogoff writes that the Krugman model is missing some absolutely essential elements to capture the problems the UK would have faced. The UK economy response after a euro breakup would more likely mean a downward shift in the IS curve because:

  1. Exports to Eurozone would falter
  2. The stock market collapse would generate a negative wealth effect
  3. Uncertainty would lower investment, and
  4. UK banks would get hammered and thus reduce lending if a disorderly euro-breakup led to a wave of defaults (especially in Ireland).


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